It was a good chat about retail stocks. I like retailers because they have inherent operating leverage that produces big swings in business performance and share prices that are often well out of step with the underlying businesses.

MHJ was touched on, and I think it's a great example of why a lot of people avoid retailers. You can see just how big the boom for them was during the covid years. Operating cash flow touched $94m, which was driven by the operating leverage flexing through the p&l but also that they became far less WC intensive with a near $50m drop in WC (I have scrubbed the WC number for excess cash). Now, invariably, that chunky cash balance back in 2023, before the Beville's acquisition would have been factored into lots of estimates of EV, but it wasn't really "excess cash" it was just that the business was operating in favourable conditions and needed less working capital (high inventory turns, sharper trading terms etc).

It doesn't appear that management got that memo, because right as the cycle started turning they went out and spent $45m (of their WC windfall) acquiring Beville's on ~5.6x EBITDA which at the mid-point of revenue and EBITDA estimates was a margin of 12.8%. But, look at how comparatively strong those last couple of years were for MHJ (annual EBITDA margins below). It's almost a foregone conclusion those Bevilles margins will end up below 10% and more like mid-single digits. So potentially, they've bought a slow growth small retailer for >10x EBITDA. Not really a bargain.

Oh, and because they did that right at the end of the boom, it was just as the MHJ business started becoming more working capital intensive too, but that $50m they took out of WC in FY21 has been spent buying Bevilles. They also increased dividends by ~50% and doubled capex and the business went from $90m net cash to $12m net debt.

There was a trading update in May were they said they had made a $10m EBIT loss in Q3, so the underlying business is now also losing money in addition to becoming more capital intensive. On top of that, they are trying to take the Michael Hill brand upmarket which will be no mean feat and if they succeed will likely cost a fair bit – there was a recent article in the AFR with the CEO talking about how their new Chadstone store had a $1m pair of earrings in it which begs the question who with $1m to spend on earrings is going into the local mid-market Michael Hill?

So yeah, consumer spending recession, repositioning brands, overpaying for acquisitions, potentially mistiming the WC cycle and the business operating at a loss. There's a time to own this business, but I have to think it's not right now.

@UlladullaDave brilliant analysis! I also think part of the difficulty with retailers is they are so easily modelled by the "spreadsheet jockeys" as @mikebrisy so eloquently put it earlier. For people who love detailed financial models, retailers are the perfect businesses as they can be broken down to store level economics pretty easy and as long as you have four or five key inputs (store count growth, same store growth, gross margin, inventory turnover, cost of doing business margin) you can click and drag that spreadsheet out a few years and things look absolutely beautiful!

Of course the real world is not that simple and the MHJ case study should be well observed by people who want to delve into retailers because even management themselves, with all of the extra data we are not privy to, make the same bloody mistake! @Rick started the thread with Brett Blundy's principles (which I had never seen before, thanks heaps for that mate!) which is a timely reminder that for cyclical businesses across all sectors it is often more important to have the right jockey than the right horse. Someone who has seen a couple of cycles for sure.

Thanks @Wini

I'm not trying to put people off retail stocks it's just that they are a lot more mean reverting than people like to admit both at the top of the cycle and the bottom – and that operating leverage can make a small change in revenue very painful.

Too many people make overly simplistic arguments like "it's on 5x mid-cycle earnings" when really the focus should be on thinking about what the cycle looks like as it passes through their financial statements – at least that's what I focus on. That theory extends well beyond retailers, DTL was another stock I wrote about a while ago as being a candidate for under-appreciated cyclicality because it's likely over-earning right now.

And getting back to MHJ and over enthusiastic management that can't delineate skill with cycles, two years ago they had the Michael Hill brand and that was it, now they have this...

You don't see that sort of segment "sprawl" at the bottom of the cycle. But it's definitely one of those soft indicators of an over-earning company that investors need to look out for. It probably also tells you a fair bit about how little growth is left in the core brand.

Great read. Retail is really a details business. Lots of little details.

So in stores - making sure the stock is out on display, the windows look good, the staff are friendly and available etc, etc.

Or in Online retail - is your site well designed and merchandised, easy to shop, cart works well, deliveries are accurate and on time etc, etc.

So the best performing retailers will need to keep doing both of these really well, if they want to stay profitable and avoid the need to either excessively discount, or pay up big for customer acquisition. It's the ability to not have to charge less and/or spend more, that is where the edge really is.

Baby Bunting and Nick Scali are both usually early reporters and have got in front of the pack by releasing full year results today.

From a very quick look both share some observations that might point to themes in the retail space as we move further into reporting season:

• Both have improved Gross Margin (NCK more so than BBN), with higher costs being passed on to customers
• Both are getting on top of inventory buildups and reporting lower inventory levels
• As a result of the above both are generating significant cashflow and cash conversion
• As a result of the cash both have reduced net debt to negligible levels (particularly impressive for NCK given the acquisition of Plush recently)
• But both have reported interest rate rises are biting and the consumer response has been sudden and recent (suggesting FY24 will be fundamentally challenging and difficult to forecast)

Interesting time for retail. I'm pretty sure we won't see the bottom in terms of results this reporting season but have we seen the bottom in terms of share price? Shoutout to Nick Scali in particular - for the past three years every pundit comes out at reporting season and acknowledges the result and then sagely questions how many new couches we will need. It turns out...lots! A ROE of 56% - unjuiced by loads of debt - is nothing to sneeze at.

[Neither currently held]

@Noddy74 great insights.

Just off the call with Anthony. There are some specifics to their story in addition to your points.

• He spoke about how folding Plush into $NCK's supply chain was the strategy stated at the time of the acquisition, and they appear to have delivered.
• Plush synergy benefits are $20m. Done.
• The easing of supply chains has allowed them to reduce inventory, primarily because order-to-delivery times have returned to pre-COVID levels
• Approaching factories with greater volume (68% $NCK + 100%Plush) is helping them "get more out of the factories" (i.e. better deals)
• This has essentially lifted the Plush %GM from 55% to $NCK's 61%-62%
• The store refurbishment and ranging uplift is improving the Plush customer proposition. ("Plush is a sofa specialist. They should have more price points.")

I enjoy hearing Anthony talk about his business - this is someone who clearly understands it, knows his customers and his competition. He teased the analysts a bit today when they asked about possible future acquisitions. He said he'd been in the UK in June and visted some of the similar retailers there. He commented on how the market in the UK is very similar to Australia. Key quotes: "The will be consolidation in the smaller networks" (thats a reference to Australia), "If opportunities come up ...", "Nothing on the horizon...." "Could look at the UK... may be potential."

No doubt, $NCK will feel pain over the next year like everyone in the category, but it is evident that they are working to build a stronger business which, as a long term investor, is what I really care about. Importantly they have the margins and balance sheet to weather any storm. I think a fair amout of "pain" is built into the p/e. But trying to pick the bottom is not my game.

In terms of my investment strategy, I initiated my position in February (1/3rd). Today in RL I have added 1/3rd on open. I am holding 1/3rd in reserve to see how the macro plays out over the next 6 months, but my bias at the moment is to add it at the HY - but I could go sooner on newsflow. Where does the 1/3rd come from? We'll so far I've resisted selling all of $ADH. The recent bad news/good story on the DHL DC has me thinking, is that positioning for a bad FY results story at $ADH on inventory, supply chain costs, customer cancellations? Their downgrade is already out there, and where I think I have settled that there is a lot of bad news baked in. In part, I want to hear how management account for their results on the next call. Today, they've benefitted from the $NCK result, but on the 21st they stand on their own. I've seen lot of empty floor space in their Carindale shop!